Capital Budgeting, its techniques and importance explained with example

Capital budgeting is also known as “investment appraisal”.

Definition

“Capital budgeting is the process of deciding whether to make investment in long term assets (fixed assets) or not.”

In other words capital budgeting is the decision making process in respect of long term assets.

Example

Apple (the famous company) has purchased the streaming radio service “Beats” which includes both Beats Audio Hardware and Beats Music. The deal was settled in $3 billion which is one of the highest deals ever. The deal is so large that the outcome of the decision will affect Apple’s future but the question arises how Apple made the decision of investing $ 3 billion. The answer lies in capital budgeting process.

Techniques / Models of Capital Budgeting

Words “techniques” & “models” are interchangeably used to refer the evaluation criteria for decision making in respect of investment in long term assets.
These techniques or models are

  1. Net present value (npv)
  2. Payback period
  3. Profitability index (benefit / cost ratio)
  4. Internal rate of return (IRR)

Importance & Significance

The importance of capital budgeting is evident from the example given above. Fixed assets decisions involve huge investments that can significantly affect a business’s future position. Therefore such decision should be made in a formal style to avoid risks and losses to the business. Capital budgeting process provides us the frame work for making safe decisions.

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